How Can Litigation Finance Help Manage Corporate Balance Sheets?
Under Generally Accepted Accounting Principles, litigation costs are reflected as expenses. Carrying and reporting such expenses can negatively impact a company’s financials and quarterly performance. This is especially true for public companies that are valued on earnings or cash flow or require certain financial criteria to be met to comply with credit obligations.
For companies in that position, litigation costs paid from company funds must be recorded as expenses when incurred, thereby diminishing reportable earnings. Moreover, even if litigation results in a favorable outcome (whether via judgment or settlement), such outcomes sometimes take months or years to enforce and actually pay out, leaving a temporary gap in a company’s cash flow despite obtaining a ruling in their favor. Worse yet, recoveries from successful legal matters may not offset the adverse impact of lawsuit-related costs because such recoveries are generally treated as below-the-line items that do not increase earnings. General counsel and in-house legal departments can shift both the risk and financial burden of litigation to third-party funding specialists in exchange for a portion of any recoveries.
For instance, litigation finance companies can make funds available in a segregated account so that law firms bill against those funds, rather than through the business, keeping the ongoing expenses off the company’s balance sheets until resolution of the matter. In this way, businesses do not have to carry and report expenses on an ongoing basis but will only have to do so at the end of the dispute. Further, once the matter resolves, the company incurs the liability of having to repay the investment but can then simultaneously report the funds received from resolution of the matter. This simultaneous reporting creates a more accurate accounting of the events because the payment to the litigation finance company (which subsumes the expenses) appears on the claimant-business’s financial statements at the same time as any recovery realized from the underlying litigation.
Ultimately, securing third-party funding for operating expenses can transform otherwise illiquid liquid claims into a valuable source of capital.
What Types of Cases Do Litigation Funders Invest In?
Litigation finance companies invest in a wide range of cases that varies based on their particular risk profile, expertise, and available capital. Whether a company’s dispute revolves around trade secrets, contracts, shareholders, IP, or some other matter, litigation finance can support virtually any claim type.
In October, LexShares published “The Litigation Funding Barometer,” an analysis of the types of cases that are often best suited for non-recourse financing. The data presented in the Barometer report was based on data produced by the firm’s proprietary Diamond Mine software, which in 2021 scored more than 30,000 state and federal cases based on several different factors. Among other conclusions, the report found that a higher percentage of strong funding opportunities existed among federal cases than state cases. Federal trade secrets, antitrust, and contract disputes also presented some of the strongest funding opportunities across jurisdictions. While this data represents the investment potential of various case types, we feel it is nevertheless a valuable gauge of how the funding industry generally views the U.S. litigation landscape.
Notably, litigation finance companies are also not limited to investing in contingency cases. Financing can be made available to hourly representation, usually requiring deferral of a portion of the hourly attorney’s rate and ongoing billing against segregated amounts.
What Are Some Attributes of Reputable Litigation Finance Companies?
Evidently, the idea of receiving funding—at some times substantial amounts of funding—from a third party can raise some concerns. Attorneys seeking out and recommending litigation finance to their clients should watch for the following things:
First, a reputable litigation finance company will implement a demanding due diligence process. While this is frustrating while already dealing with the litigation process, a robust underwriting process signals a serious partner. The old adage holds true: if something is too good to be true, it probably is.
Second, a litigation finance company should never attempt to control or direct the litigation. There are a number of reasons for this, including rules of ethics pertaining to an attorney’s duty of loyalty. If a litigation finance company attempts to insert itself into the actual litigation, this is a sign that another funder may be a better choice.
Reputable litigation finance companies are an excellent resource for savvy businesspeople and their legal advisors. Careful vetting and selection of that tool is of paramount importance.
In-House Legal Departments Leveraging a Powerful New Tool for Accessing Justice.
Maya Steinitz, a legal scholar and University of Iowa College of Law professor, refers to litigation finance as “likely the most important development in civil justice of our time.” As founders and executives grow more familiar with commercial litigation finance as a useful financial resource, the potential appeal of offsetting litigation risk and optimizing corporate balance sheets for legal action stands to become more mainstream. For CEOs and founders weighing the prospect of litigation, the ultimate question is no longer why they should be using litigation finance. The real question is: why not?